Friday, November 28, 2014

I think it's fair to say that it's never been easier to minimize frictional costs when it comes to investing in stocks.

Transaction costs these days are, at many brokerages, reasonable or better for stocks and ETFs.

Many fine low cost fund alternatives exist.

Yet what should be plain advantage is often converted into a curse.

In this CNBC appearance back in October, Warren Buffett said that "if you are buying a business to own...the idea of what the market does on any given day, it's just meaningless. What you really have to look at is where you expect the business to be 5 or 10 or 20 years from now."

That's how most will think about businesses that aren't traded daily but, because stocks are quoted so frequently, behavior is changed for the worse.

"...you can look at stock prices minute by minute. And that should be an advantage but many people turn it into a disadvantage."

"Those people who can sit quietly for decades when they own a farm or apartment house too often become frenetic when they are exposed to a stream of stock quotations and accompanying commentators delivering an implied message of 'Don't just sit there, do something.' For these investors, liquidity is transformed from the unqualified benefit it should be to a curse." - From the 2013 Berkshire Hathaway (BRKa)Shareholder Letter

Low frictional costs and the convenience of buying and selling creates a temptation to try and be in and out of certain things at just the right time. What then usually happens is -- as a result of this behavior -- not only is the low frictional cost advantage lost or reduced, unnecessary mistakes get made. Making judgments about how price compares to value is far from easy, but it can be done. Mistakes occur when attempts at timing is added to the equation. Stocks move unexpectedly. Timing when to buy or sell, if not impossible, is difficult to do reliably well. Nor is it necessary. What matters far more is a reasonable appraisal of business value combined with patience and price discipline. Get that right and, in the long run, good things are more likely to happen.

Attempts at timing are more likely to subtract or, at a minimum, distract from what really counts.

So that means the relationship between price and value -- along with opportunity costs -- should primarily dictate action; timing should not.

Part of the problem is that some behave as if the mistakes will only be made by the other participants. Morgan Housel explains this tendency -- what's known as the bias blind spot -- the following way:

"People love reading about flaws people fall for when handling money. But few of them admit, or even realize, that they're reading about themselves."

He adds: "We're blind to our blindness."

Some think they can be in the right stock (or stock fund) at just the right time. What happens instead is they end up just compounding mistakes and incurring unnecessary costs when much less activity would have yielded a vastly better outcome.

Liquidity is much overrated. It can be an advantage, of course, but only up to a point.

"A modest amount of liquidity will service the true needs of a civilization. A large amount of liquidity will bring out the worst in human nature." - Charlie Munger at the 2008 Wesco Financial Shareholder Meeting

The risk that a stock or fund that's been bought might drop substantially gets most of the consideration. Loss aversion contributes greatly to this. Yet the risk that what can be bought sensibly today may at some point not be available at attractive prices -- though not in a predictable manner as far as timing goes -- deserves at least equal attention.

"Since the basic game is so favorable, Charlie and I believe it's a terrible mistake to try to dance in and out of it based upon the turn of tarot cards, the predictions of 'experts,' or the ebb and flow of business activity. The risks of being out of the game are huge compared to the risks of being in it." - From the 2012 Berkshire Hathaway (BRKa) Shareholder Letter

Those who try to "dance in and out" aren't giving due consideration to the risk of not participating sufficiently. They think they'll be in and out at the right times. Somehow, they'll consistently avoid the downside while capturing the upside. Easier said. If the share price of a lousy business drops that, of course, can be a real problem. On the other hand, for those who feel comfortable judging prospects and value, if the share price of a sound business temporarily drops that's far from a problem for the long-term investor.

More from Buffett's CNBC appearance back in October:

"I don't know how to tell what the markets going to do. I do know how to pick out reasonable businesses to own over a long period of time. And a lot of people do, incidentally."

It's, in fact, an opportunity when prices fall.

"The stocks I was buying yesterday I hope go down today. Put it that way. And I hope they go down next week, and I hope they go down the week after. Nothing is going wrong with the companies."

Effectively judging business economics is paramount when buying an individual stock. For some, that's where a good fund might be more suitable.

Many stocks, these days, have become quite expensive or, at least, not cheap. Though there are always individual exceptions, the time to buy with a substantial margin of safety, at least for now, has mostly passed.

Stocks may continue rising, of course, but those gains increasingly will be driven by speculation instead of increases to intrinsic value. When stocks will become broadly undervalued again, and what the cause will be, is always uncertain. Those who still think bull markets are such a wonderful thing might want to keep these things in mind.

Bull markets make it more difficult to accumulate meaningful positions.

Managing risk and reward just becomes more challenging.

Liquidity should be an advantage. Well, at least it should be for those who tend to buy pieces of sound businesses with the idea that gains will come primarily via long-term intrinsic value increases. Returns should mostly driven by the compounded effect of what the businesses produce -- free cash flow generated at high returns on capital -- for owners over the long haul. Too often, instead, the focus is profiting from near-term price action; the focus is on speculative bets on where prices are going.

So, as a result, what ought to be beneficial liquidity morphs into a curse.

Broadly speaking, outcomes likely improve when there's greater emphasis on what businesses -- whether owned as individual stocks or through a fund -- can produce over a very long time.*

To me, there should be much less emphasis on the wonders of liquidity.

As always, what's sensible to buy at one price becomes less so as prices increase.

So buying at least reasonably well (i.e. a nice discount to conservatively estimated value) in the first place naturally matters a great deal.

Investment results ought to be mostly about long-term increases to per share intrinsic value.

They shouldn't be dependent on selling at speculative prices.

Adam

Long position in BRKb established at much lower than recent market prices* This naturally also applies to owning a business outright for those inclined and able to do so.

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Origin of Newton's 4th Law?

"Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac's talents didn't extend to investing: He lost a bundle in the South Sea Bubble, explaining later, 'I can calculate the movement of the stars, but not the madness of men.' If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases." - Warren Buffett

About The Site

This site is for generalized informational purposes only and the views found here should never be considered specific investment advice.

Visitors should always do their own homework and consult, as needed, with a personal financial adviser who understands their specific individual circumstances before taking action on any particular investing idea. What makes sense as an investment in one set of individual circumstances may not in another.

Opinions found on the blog are just that, opinions, could easily be wrong in all kinds of ways, and should never be considered advice that is specific in nature. Stocks and other investment vehicles are inherently filled with risks including the possibility, or even likelihood, of permanent loss of capital. Past performance, of course, should not be considered indicative of future results. Due diligence is necessary.

The content found here shall not be taken as a recommendation to buy or sell any security or to participate in any particular investment strategy. Again, that necessarily comes down to individual circumstances. So, in other words, there is no personal financial adviser here, just some opinions and views. These opinion and views are subject to change at any time and, since they are not individualized in any way, consultation with an investment professional and doing one's own rigorous research/analysis before making any investment decisions is essential.

All posts are simply presented as one view on investing and some related topics though never specific recommendations. An investor should always get help from an investment professional if they feel they need it and, most importantly, before mistakes are made. Ultimately, the actions of individual investors, whether they happen to be a visitor to this site or not, are their own responsibility (and, if applicable, so are the associated losses). While there will always be a very real risk of permanent capital loss in investing, those who know their own limits and ask for professional advice when they require it can improve their chances substantially. Investors should never buy or sell a security based upon what they've read on any blog.

Information on this site is believed to be accurate yet may include errors or omissions and is not guaranteed. The site is also never a solicitation or offer to buy or sell any securities.

Posts on this blog do not offer opinions on the future price action of specific stocks or the capital markets as a whole. Instead, the focus is sound investing principles but never predictions or recommendations. It's understanding productive assets and their likely intrinsic value; how they may or may not compound in intrinsic worth over a long time horizon. It's about investing with a comfortable margin of safety. It's NOT about speculating on price action. In the near-term, or even longer, the market price of an asset can do just about anything.

A temperamental market pretty much assures it.

Those with a long investing horizon, it's worth noting, actually benefit from lower stock prices in the near-term (though not many market participants seem willing to put this truism to effective use). Those who attempt to profit primarily via speculating on short-term price action likely won't find this way of thinking to be of much interest.

The bottom line: This site does not provide individual investment advice of any kind and the blog posts found here are never a recommendation to buy or sell anything. Visitors should start with the assumption that the ideas found here are not good ones and do their own homework (or get individualized help from an investment professional) before taking ANY action.

This site's emphasis? Put simply, it's on finding and buying -- with the long-term in mind -- good businesses at a plain discount to conservatively estimated value; it's on selling shares of those well-bought high quality business reluctantly. The view here is that selling makes sense only when core economics become permanently impaired, prospects have been misjudged, market price not just somewhat but, instead, meaningfully exceed per share intrinsic value, or opportunity costs are high. Buy/sell decisions aren't just an opportunity to increase returns; they're also an opportunity to make mistakes. It's easy to overemphasize the former and forget the latter. The focus here is on minimizing trading, frictional costs, and errors of all kinds; it's on staying comfortably within realistically assessed limits. First and foremost is the view that an investor should never make a specific investment based upon what someone else thinks. In other words, what makes sense to own is necessarily unique for each investor and it'd be unwise to not act accordingly. So, more generally, this site simply attempts to better understand some useful principles and ideas in context of investment. It's about, in a practical sense, what tends to work over the long haul as well as what, at times, gets the investor into trouble. It's not about grand theories in finance and economics. These too often distract from what matters or, worse yet, lead to costly misjudgments. As a result, they are mostly viewed with a healthy dose of skepticism here. Otherwise, the best thinking across disciplines should be learned well then put to good use in a way that's uniquely suitable.

About

Notable Quote

"Warren and I have not made our way in life by making successful macroeconomic predictions and betting on our conclusions.

Our system is to swim as competently as we can and sometimes the tide will be with us and sometimes it will be against us. But by and large we don't much bother with trying to predict the tides because we plan to play the game for a long time.

I recommend to all of you exactly the same attitude.

It's kind of a snare and a delusion to outguess macroeconomic cycles... ...very few people do it successfully and some of them do it by accident. When the game is that tough, why not adopt the other system of swimming as competently as you can and figuring that over a long life you'll have your share of good tides and bad tides?" - Charlie Munger